Companies have different ways of financing their operations. Some will rely solely on equity, while others will lean more heavily on debt. Most companies employ a mixture of the two that can vary depending on the company’s business model and its capital needs. Funds secured from an outside lender are referred to as debt, while equity refers to money that owners and shareholders invest directly into the company, but what is an optimal capital structure for your business?
The capital structure, or the ratio of debt to equity forms the basis of the company’s weighted average cost of capital. By minimizing financing costs and maximizing the company’s value, the company can optimize its debt-to-equity ratio.
Calculating the amount of debt and equity a company holds will illustrate the company’s exact capital structure. To do so, first multiply the percentage of debt the company holds by its cost to carry the debt. The cost is the rate of interest at which the debt needs to be repaid. Next, determine the cost of equity by multiplying the percentage of equity by its cost. Equity costs are typically the dividends the company pays to owners and shareholders. Adding these two sums together reveals the company’s weighted average cost of capital.
Why capital structures matter
The cost of debt is usually less than the cost of equity. Whereas shareholders may expect dividends, debt may be financed at a lower rate. In addition, interest on debt remains tax-deductible, which can make it an attractive option over equity. However, carrying a disproportionately large debt-to-equity ratio may cause lenders to raise interest rates if there’s increased concern about the company’s ability to repay the loan. If the cost of debt increases considerably, it can prompt concerned shareholders to demand a higher return on their investment as well. These factors will drive up the weighted average cost of capital, which can have a detrimental impact on the company.
Companies need to ensure they maintain a manageable weighted cost of capital to achieve an optimal capital structure. This ensures both debt and equity obligations are paid in a timely fashion and the costs of the financing options don’t ultimately bankrupt the company.